Sell Puts to Profit in Gold

Volatility in the precious metal is high -- play for more upside with this trade

The markets have been whipped around following the recent resolution of the presidential race. From the looming “fiscal cliff” to earnings deterioration to recession fears, reasons for the selling pressure abound. Of course, the rationale for the stock market’s recent bout of weakness is irrelevant — uptrends have been broken, and the bears have inflicted serious wounds. Want to position yourself for more broad market weakness? Think gold.

One of the more ominous developments is the simultaneous rise in U.S. Treasuries (as tracked by iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT)), the U.S. dollar (PowerShares U.S. Dollar Bullish (NYSE:UUP)), and gold (SPDR Gold Shares (NYSE:GLD)). While it’s not that surprising that investors have flocked to Treasuries and the greenback — they usually do when risk aversion rules the day — it’s interesting that gold is rallying as well. Under normal conditions, gold moves in opposite direction of the other two as a falling dollar is viewed as inflationary (gold rises) and a rising dollar non-inflationary (gold falls).

Such a strong correlation between these three assets indicates the extreme levels of risk aversion influencing investors over the past week — and it’s a bad sign for the stock market.

The uptick in demand for gold has lifted the beleaguered precious metal out of its recent downtrend and back above its declining 20-day moving average. Those who have been waiting for the GLD correction that began in October to terminate may well have received their bullish reversal signal this week. If indeed the longer-term uptrend in gold is beginning to reassert itself, bullish trades should fare much better going forward.

The resurgence in gold prices has also increased investor appetite for GLD options. We can gauge demand for GLD options using the so-called gold VIX — the Gold Volatility Index ETF (NYSE:GVZ). As seen on the accompanying chart, GVZ has lifted notably off its lows at the 14 level, which means GLD options are the most expensive they’ve been in the past month in implied volatility terms. This is obviously a welcome development for option sellers, as they will now receive more credit when initiating their positions.

Traders looking for bullish exposure to GLD might consider selling December out-of-the-money put spreads. For example, you could sell the December 161 put while buying the December 156 put for a net credit of $0.62 or better. Provided GLD remains above $161 by December expiration you will capture the entire $0.62, which represents a return on investment of 14%.

GLD has risen considerably already this week, so I’d prefer to see a one- to three-day pullback before initiating the position. To minimize the risk, consider closing the trade if GLD falls beneath its 200-day moving average at $161.50.

At the time of this writing Tyler Craig had no positions on any of the aforementioned securities.